Distressed debt funds are turning their focus from bankrupt companies to struggling cities and counties — and no place beckons more than Detroit

In the past two decades, a group of specialized hedge funds have transformed corporate bankruptcies, injecting much-needed capital while at the same time drawing fire as “vultures.”

Now these same funds may be poised to descend on another landscape: struggling cities and counties — and no place beckons more than Detroit.

This sudden interest in the staid world of municipal debt comes as these so-called distressed funds are looking for new places to put their money. Lucrative corporate bankruptcies have dried up, thanks in part to the Federal Reserve’s policy of low interest rates.

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Of course, these hedge funds may be deterred by the financial and political constraints of local governments, which must pay police and collect trash and cannot be forced into liquidation.

But despite the risks, some are already betting hundreds of millions of dollars that there are big returns in cash-strapped governments.

Monarch Alternative Capital, which played a major role in the bankruptcy of Twinkie-maker Hostess Brands Inc, and several other funds have scooped up more than US$600 million of debts of Jefferson County, Alabama, according to court records.

But nowhere is attracting more attention than Detroit.

Everyone is looking for ways into Detroit. It’s new and unique

With US$8.6 billion in long-term debt, Detroit would be comparable to the biggest corporate failures if it eventually files for bankruptcy, a major advantage for big hedge funds that are used to investing hundreds of millions of dollars at a time.

The sheer size of Detroit’s debt should make it easier for the funds to track down very large chunks of bonds, magnifying their profit potential, cutting their research and advisory costs and giving them leverage when it comes to restructuring talks.

Jeff Kowalsky/Bloomberg

Bill Nowling, a spokesman for the city’s emergency manager, Kevyn Orr, said the city is still assessing its approach to its financial turnaround and said he was not aware of any contact with potential hedge fund investors.

Detroit was once America’s fifth largest city and a thriving center of U.S. industry. Now, its population has plummeted to 700,000 from a peak of 1.8 million, a third live in poverty and basic services such as street lighting have broken down. Michigan Governor Rick Snyder appointed Orr, a corporate bankruptcy expert, in March to take over the city’s finances.

Even if the city does not file for bankruptcy, its debt will likely be restructured, providing an opportunity for hedge funds to make a profit.

ROADS TO DETROIT

Financial advisors, restructuring consultants and lawyers who work with the funds have told Reuters they have been fielding calls, digging through documents and even flying to Detroit as they try to pinpoint a profitable investment.

“Everyone is looking for ways into Detroit. It’s new and unique,” said Marti Kopacz, who founded Brant Point Advisors, which provides turnaround advice to municipal governments.

One of the normally secretive distressed debt fund managers confirmed the funds are circling the Motor City.

“Detroit is something we as well as other funds have looked at,” said Alan Mintz, the founder of Stone Lion Capital, which was spun out of Paul Tudor Jones’s Tudor Investment Corp.

Like Monarch, Stone Lion has bought tens of millions of dollars of Jefferson County’s debt and has also been involved in the bankruptcy of Eastman Kodak Co, among other big corporate failures.

The hedge funds’ interest in municipal debt reflects the divergent fortunes of Wall Street and Main Street.

Distressed debt funds love to jump in when most bail out. But with the coffers of U.S. companies overflowing with cash, there has been a dearth of the debt defaults, bankruptcies and liquidations that such funds normally feast on.

By contrast, a small but potentially growing number of U.S. cities and towns are struggling with pay and pension obligations that they took on in the boom years. As well as Jefferson County, the California towns of Stockton and San Bernardino have recently filed for bankruptcy.

Distressed debt investing has been one of the most successful hedge fund strategies over the past decade. Funds such as Oaktree Capital Management and Appaloosa Management buy large portions of a company’s debt and use teams of top-flight lawyers and advisors to control a bankruptcy.

In the Chapter 11 of Visteon Corp, hedge funds scooped up the car part maker’s bonds at pennies on the dollar and raised US$1.6 billion to pay off the company’s secured lenders, who had expected to own the reorganized company. The hedge funds ended up controlling Visteon, notching up large profits.

WAYS TO INVEST

Hedge funds are considering various approaches when it comes to local governments, including asset sales and loans, but in the case of Detroit the bonds are the big draw.

“If Detroit’s debt goes way, way down in value they will snap it up in the market and work for solutions that might help get Detroit back on its feet,” said Lewis Feldman, who heads the public-private development practice at the law firm Goodwin Procter.

Earlier this year, a US$25 million block of Detroit’s pension certificates traded at around 66 cents on the dollar. The buyer is unknown, but Matt Fabian of the Municipal Market Advisors research firm suggested it could be a sign of hedge fund involvement.

Explaining one hypothetical strategy, Fabian estimated that hedge funds could make a great return by negotiating repayment from Detroit as low as 80 cents on the dollar on those certificates.

While that would sting investors who bought the same debt at par, it would obviously help Detroit.

“They would do good for the citizens of Detroit and their own pocket,” Feldman said.

Fabian said a discounted repayment might chip away at the long-standing belief that muni bonds, even ones issued by a bankrupt government, are always repaid at par. That could send debt prices lower, creating more distressed muni bonds for the hedge funds to buy, he said.

Mintz, of the Stone Lion hedge fund, played down Fabian’s scenario, although he said the funds would consider accepting a below-par repayment where warranted. “Just to gratuitously offer discounts probably wouldn’t happen,” he said.

You can’t liquidate a city

EUROPEAN BANKS

Detroit may have another ingredient to attract distressed debt hedge funds: motivated sellers.

Hector Negroni, the co-chief executive of Fundamental Credit Opportunities, a fund that specializes in muni market investing, said a significant amount of Detroit’s roughly US$1.5 billion in pension certificates is held by foreign banks.

Some advisors anticipate those banks would prefer to sell their large holdings rather than slug it out in politically charged restructuring talks overseas.

A similar situation has played out in the Jefferson County bankruptcy. A unit of Britain’s Lloyds Banking Group and French bank Societe Generale have been selling warrants to the hedge funds, according to court records.

But advisors and lawyers in the municipal world warned that while there may seem to be significant opportunities in restructuring local governments, skills honed in corporate bankruptcy may not apply.

“I think it will be a period of time where the distressed investor community will come to an appreciation that these situations are so very, very different from a commercial bankruptcy,” said Kopacz, the municipal advisor.

“Everyone points to the politics but it’s even more fundamental than that. If you live in the north you have to take care of the snow and you have to have a police department and a fire department. You can’t liquidate a city.”